Can't refinance without mortgage

Don Taylorq_v2.gifDear Dr. Don,We are planning to remodel/renovate our house. We paid off our mortgage in the middle of last year and don't have any major debts other than our monthly expenses, which we put on one credit card. Our FICO scores are in the 800s.

We need about $200,000 for the renovation project but are not sure if banks will allow refinancing since we don't have any loan on the home. We are also not sure if the best option would be to refinance or take a home equity loan or a HELOC.-- Stanley Structure

a_v2.gifDear Stanley,It's not a refinancing if there's not an outstanding mortgage on the house. You might want to consider a construction loan that can be replaced with a mortgage when the remodeling and renovations are complete. Other options include a home equity loan, a home equity line of credit or a cash-out first mortgage. The goal should be to minimize the total after-tax cost of financing the project.

Consider the deductibility of the mortgage interest based on the type of financing you use. IRS publication 936, Home Mortgage Interest Deduction, explains the issue in depth. The quick reference from that publication is provided in "Figure A. Is My Home Mortgage Interest Fully Deductible?" Work with your tax professional if you're uncertain about the deductibility of the mortgage interest expense.

Another part of the financing decision rests on what the home will appraise for now, and what it will appraise for after it's been renovated. You're concerned about the mortgage's loan-to-value, or LTV. If you have an LTV of less than 80 percent, the lender will require private mortgage insurance. While it's possible to improve a home too much, or to not see a dollar-for-dollar increase in the home's appraised value based on the money spent for renovations, your LTV after the project is likely to be much higher than the LTV before the project.

So, using construction financing upfront and then securing permanent financing after the project's completion may allow you to avoid the expense of private mortgage insurance. Another advantage of a construction loan is that you don't have to take all the money out at once. Instead, you can draw down on the loan as needed during renovations.

A way to secure temporary and permanent financing with just one loan closing is with a construction-to-permanent loan. If you think mortgage interest rates are headed higher, locking in the permanent financing today is advantageous, although the rate lock has to last until the renovation is complete.

HELOCs and home equity loans aren't designed for short-term financing and may have prepayment penalties associated with paying them off in the first few years after closing on the loan. This is important if you want to do a cash-out refinancing to retire the home equity debt after the project is complete. A cash-out first mortgage taken out at the start of the project is going to run into loan-to-value issues. The home equity loan or line could also face this issue.

Your best option is likely to be either a construction loan that will later be replaced with a mortgage, or a construction-to-permanent loan that accomplishes the same financing goals with one loan closing.

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